UK inflation overshoots again, increasing pressure for higher prices

(Bloomberg) — U.K. inflation remained higher than expected for a fourth month, prompting a flurry of bets that the Bank of England will raise interest rates to near 6% and raise the cost of mortgages.

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The consumer price index rose 8.7% in May, the same as the previous month, the Office for National Statistics said on Wednesday. Core inflation, excluding food and energy, unexpectedly accelerated to a 31-year high of 7.1%. Economists had expected a headline reading of 8.4% and no change for the core.

The figures raise the specter of the Bank of England opting for a bigger rate hike on Thursday, adding to the fastest monetary tightening in four decades. A separate report showed that national debt now exceeds the size of the UK economy for the first time since 1[ads1]961, jeopardizing Prime Minister Rishi Sunak’s pledge to restore the health of the public finances and cut inflation.

“It looks increasingly likely that it will take a recession to finally get the inflationary genie back in the bottle,” said Stuart Cole, chief macro economist at Equiti Capital in London.

Traders bet on more BOE interest rate hikes. Money market prices fully priced the policy rate to 6% by December. Investors see about a 50% chance that officials will opt for a larger half-point hike on Thursday.

Suank’s government convened lenders to talk about how to support homeowners struggling with mortgages, with more than 1 million due to refinance this year at significantly higher rates. That, together with a price squeeze, is pushing several families to the brink a little more than a year away from the deadline for the next election. The BOE’s decision Thursday is likely to crystallize those concerns and push the issue higher on the political agenda.

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“There is a strong case for a 50 basis point hike at tomorrow’s Bank of England meeting,” said Charles White Thomson, CEO of Saxo UK. “The bank must take the initiative quickly. The risk of further policy failure is real, and the stakes are getting higher and higher.”

What Bloomberg Economics Says…

“May’s surprise rise in core inflation will cast a large shadow over the Bank of England’s June meeting. While we still think a 50 basis point increase is unlikely, there is now a good chance that a minority will vote for a bigger move. The central bank’s messaging is also likely to be more hawkish, although we think any adjustments are likely to be quite measured – interest rate expectations have risen since the BOE last met, but it’s not clear they need another push higher.”

—Dan Hanson and Ana Andrade, Bloomberg Economics. Click for REACT.

The BOE has raised interest rates at 12 consecutive meetings from 0.1% to 4.5% and is expected by economists to raise them by at least a quarter point to 4.75% on Thursday. Mortgage interest rates have now passed the level of 6%, which is well into the territory BOE has described as problematic, and further interest rate increases are likely.

“It is possible that the Bank will raise rates by 50 basis points tomorrow and will need to raise rates above 5.25% to top core inflation,” said Paul Dales, UK chief economist at Capital Economics.

Britain remains an outlier among major economies with prices rising more than four times faster than the central bank’s 2% target. BOE Governor Andrew Bailey is worried about signs that inflation remains more persistent despite the fastest round of rate hikes in four decades.

Used car prices along with airline tickets and the cost of recreation and culture drove the increase, suggesting that price pressures have moved beyond food and energy into the rest of the economy.

“The cost of air tickets rose by more than a year ago and is at a higher level than usual for May,” said Grant Fitzner, ONS chief economist. “Live music events and computer games also contributed to inflation remaining high. These were offset by a fall in petrol costs. Food price inflation is still high, but the price has fallen slightly.”

“High headline inflation is increasing pressure for more rate hikes,” said Yael Selfin, chief economist at KPMG UK. “Today’s data is likely to leave the Bank of England with no choice but to opt for another increase in the base rate tomorrow.”

Two price targets closely watched by the BOE for signs of domestically generated inflation rebounded. Core inflation – which excludes volatile food and energy prices – unexpectedly accelerated to a new 30-year high of 7.1% while services prices rose 7.4%, up sharply from a 6.9% increase in April.

The deficit is rising

In a separate report, the ONS said national debt climbed above 100% of GDP for the first time since 1961 after the government borrowed more than expected by 20 billion pounds ($25.6 billion) in May.

The deficit, second highest for the month since modern records began in 1993, was up from 9.4 billion a year earlier. The increase was driven by cost of living payments including energy subsidies and higher staff costs.

The figures make it difficult for Sunak to deliver the large tax cuts that many Conservatives believe are necessary if the party is to avoid defeat in a general election expected to be held next year.

High inflation and rising interest rates also weigh on public finances. Debt servicing costs for May alone were £7.7bn, £700m more than the Office for Budget Responsibility forecast.

Public strikes, as workers demand wages keep pace with prices, have yielded bigger pay deals than the government had planned.

As a result, staff costs in May were £3.4bn higher than last year – mainly due to the NHS pay deal. Support for household energy bills cost £3.6bn in May, £1.4bn more than last year. Inflation also added £2.9 billion to welfare spending, as benefits were upgraded in line with inflation in April.

Chancellor of the Exchequer Jeremy Hunt said the priority is to fight inflation.

“We will not hesitate in our decision to support the Bank of England as it tries to push inflation out of our economy, while providing targeted cost of living support,” Hunt said in a statement. “We know how much high inflation hurts families and businesses across the country, and our plan to cut the rate in half this year is the best way we can keep costs and interest rates down.”

Inflation is falling more slowly in the UK, partly because falling commodity prices are being passed on to regulated domestic energy bills with a lag. Britain also saw more than 500,000 people drop out of the workforce during the pandemic, forcing companies to bid up wages to secure the staff they need.

Bailey said last week that inflation will come down, but that it will take “much longer than expected”. He warned of a “very tight” labor market, stressing that many firms are hoarding workers because of the difficulties in recruiting.

Slower inflation is crucial to the political fortunes of Sunak, who made halving inflation by the end of the year one of his five most important promises.

Read more:

• UK heading for recession if prices hit 6%, economist says

• Why UK inflation is so high and hard to bring down: QuickTake

–With assistance from Andrew Atkinson, Elina Ganatra, Greg Ritchie and Aline Oyamada.

(Updates with context about mortgages and comment from the first paragraph.)

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